Before you dive into DCFs, LBOs, and M&A, you need the foundations. Every technical concept tested in investment banking interviews builds on a handful of core finance principles. If you understand these properly, everything else clicks into place. If you don't, you'll struggle to explain 'why' when interviewers push you.
This guide covers the fundamental finance concepts that underpin everything in IB interviews. It's everything you actually need to know – whether you're a finance student or a career changer from a completely different background.
Time Value of Money
This is the single most important concept in all of finance. The core idea: a pound today is worth more than a pound in the future, because you could invest that pound today and earn a return on it.
Two key calculations flow from this:
Future Value (FV): If you invest £100 today at 10% per year, in one year you have £110. In two years, £121. This is compounding – earning returns on your returns.
FV = PV \times (1 + r)^n
Present Value (PV): If someone promises you £100 in 2 years and the discount rate is 10%, that's worth £100 / (1.10)^2 = £82.64 today. The formula is \text{PV} = \text{FV} / (1 + r)^n. This is discounting – the foundation of all DCF analysis.
Every valuation technique in investment banking is ultimately about discounting future cash flows or comparing present values. The DCF literally applies this formula to every year of projected cash flow. Understanding time value of money means understanding why a DCF works.
If asked 'why is a pound today worth more than a pound tomorrow?', don't just say 'inflation'. The real answer has three components: opportunity cost (you could invest it), risk (future payments are uncertain), and inflation (purchasing power erodes). Hit all three.
The Three Financial Statements
There are three core financial statements and every IB candidate must know what each one shows and how they connect. This gets its own dedicated blog, but here's the foundation:
Income Statement (P&L): Shows revenue, expenses, and profit over a period. Starts at Revenue, deducts COGS (giving Gross Profit), deducts operating expenses (giving EBIT), deducts interest and tax (giving Net Income). Tells you how profitable the business is.
Balance Sheet: A snapshot of what the company owns (Assets), owes (Liabilities), and what's left for shareholders (Equity) at a point in time. Assets = Liabilities + Equity. Always.
Cash Flow Statement: Shows actual cash movements over a period, split into three sections: Operating (cash from the business), Investing (CapEx, acquisitions), and Financing (debt raised/repaid, dividends, share buybacks). The bottom line is the change in cash, which must tie to the cash balance on the Balance Sheet.
The link between them: Net Income from the Income Statement flows into Retained Earnings on the Balance Sheet and is the starting point of Cash Flow from Operations. This is the backbone of the 'walk me through the financial statements' question.
Key Financial Ratios
Interviewers won't quiz you on 50 ratios. But you need to understand the major categories and what they tell you about a company.
Profitability: Gross margin, operating margin, net margin, ROE, ROA, ROIC. These measure how efficiently the company converts revenue into profit and returns capital to investors.
Liquidity: Current ratio (Current Assets / Current Liabilities) and quick ratio ((Current Assets – Inventory) / Current Liabilities). Can the company pay its short-term obligations? A current ratio below 1.0 means it might struggle.
Leverage: Debt/Equity, Debt/EBITDA, Interest Coverage. How much debt does the company carry relative to its size and earnings? Debt/EBITDA above 4–5x is considered highly leveraged in most industries.
You don't need to memorise every ratio formula – check our formula cheat sheet for the complete list. What matters is understanding what each category tells you and being able to explain why a specific ratio matters in context.
Capital Structure and WACC
Capital structure is how a company finances itself – through some mix of debt and equity. This matters because the cost of each source of capital is different, and the blend determines the company's overall cost of capital (WACC).
Debt is cheaper than equity. Debt holders take less risk (they get paid first in bankruptcy and receive fixed interest payments), so they accept a lower return. Plus, interest payments are tax-deductible, making debt even cheaper after tax.
But debt is riskier for the company. More debt means higher fixed obligations. If the company can't make interest payments, it goes bankrupt. Equity has no such obligation – you can skip dividends without defaulting.
WACC blends these costs together based on their proportions in the capital structure. It's the discount rate used in DCF analysis, and it represents the minimum return the company must earn to satisfy all its investors. Our formula cheat sheet has the full WACC formula.
A classic interview question: 'What happens to WACC if the company adds more debt?' The answer: initially WACC falls (because debt is cheaper than equity), but beyond a certain point, both cost of debt and cost of equity increase due to higher bankruptcy risk, and WACC starts rising. The optimal capital structure minimises WACC.
Risk and Return: CAPM
The Capital Asset Pricing Model gives us the cost of equity – the return equity investors expect based on the risk they're taking.
R_e = R_f + \beta \times \text{ERP}
Risk-Free Rate: The return on a 'zero-risk' investment – typically the 10-year government bond yield.
Beta: How volatile the company is relative to the market. Beta of 1.0 = moves with the market. Beta of 1.5 = 50% more volatile (and 50% higher expected return). Beta of 0.7 = less volatile (and lower expected return).
Equity Risk Premium (ERP): The extra return investors demand for holding stocks instead of government bonds. Typically 5–7%.
The intuition: riskier companies have higher betas, which means investors demand higher returns, which increases the cost of equity, which increases WACC, which reduces the present value of future cash flows in a DCF. Risk and value are inversely related.
Why Banks Care About All of This
Investment banks advise on three things: buying companies (M&A), selling companies, and raising capital (debt or equity). Every one of these activities requires understanding: how much is this company worth (valuation), how should it be financed (capital structure), and what returns will investors require (WACC/CAPM). The finance fundamentals aren't abstract theory – they're the toolkit bankers use every day.
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